Behavioural finance and rational thinking

  • Investment management
  • 5 minute read

Training, research, and robust processes help to guard against emotional errors and facilitate better investment decision-making.

Humans are not always as rational as we think we are – even when it comes to making big, important decisions about our money. Yet the theories of economics and standard finance rely on people behaving rationally. While you or I may have a fairly liberal definition of ‘rational’, financial economists define it quite specifically. In 1961, Merton Miller and Franco Modigliani identified that rational investors “always prefer more wealth to less”. They never fall foul of cognitive and emotional errors, and would never use a cognitive shortcut to get to a decision more quickly. Every decision a rational investor makes is intended to reach the optimum level of benefit.

But we know that these characteristics don’t fit the profile of normal investors. Studies have continually shown “repeated patterns of irrationality, inconsistency and incompetence” when participants are tasked to make decisions in uncertain conditions. Hence, the truly rational investor is somewhat a myth.

In his book, Behavioral Finance: The Second Generation, finance professor Meir Statman describes the normal investor as capable of making what economists may deem irrational decisions. Normal investors are susceptible to cognitive and emotional biases and they care about more than just the utilitarian (high-return, low-risk) benefits of investing. So, how do these biases and concerns affect normal investors’ decision making?

Dual-system theory

One of the best known, simple frameworks from behavioural science is that of dual-system thinking. System 1 is our intuitive, ‘blink’ system, characterised by fast, automatic, emotional thinking. System 2 is the analytical system, used for slow, effortful and logical thinking. These systems were first proposed by psychology professors Keith Stanovich and Richard West, and described by Daniel Kahneman, the Nobel Prizewinning psychologist and economist. Kahneman is the author of bestselling book Thinking, Fast and Slow.

Often, System 1 guides us to make good choices and is more convenient, but it can lead us astray. For example, when you get in the car and effortlessly drive to work, you are mostly relying on System 1 and it leads you to a good outcome. When you see a market downturn, however, System 1 can jump to conclusions and prompt fear and panic – quick, emotional responses, which can make you want to pull out and sell your holdings. It’s this kind of emotional bias that can cause investors to sell when the market is low and buy when the market is high, potentially leading to suboptimal results. Fortunately, this is where System 2 comes in. Humans default to using as little brain power as possible on any given task (which is where System 1 excels, with its rapid thinking, shortcuts and rules of thumb). Yet sometimes we need to take time to reflect. If you are choosing investments to fund your retirement, you probably don’t want to be relying on System 1. But what if your System 2 isn’t well equipped to make those decisions either? The answer to that question lies in education and expert advice.

Examples of System 1 and System 2 thinking in a market downturn:

System 1 - Thinking, based on feelings of anxiety and despair:

  • “Oh no, my portfolio has dropped in value. I should never have invested at all. Maybe I should just get all my money out now?”

System 2 - Thinking, based on taking an analytical approach:

  • “Any market analysis will show that the value of my portfolio will fluctuate over the short term.”
  • “It is only when I sell that I realise a loss, so it may be better to ride the wave, knowing that markets act cyclically and ups and downs are to be expected.”
  • “Since investing is a long-term strategy, what happens in the short and medium term is not relevant unless I urgently need cash.”

The trusted adviser

Training, research and robust processes exist to bring financial professionals closer to the concept of the rational investor. They therefore position financial professionals to perform complex decision-making tasks on behalf of amateur investors. Similarly, effective committees perform System 2 functions in an effortful way for a group, so that decision-making is not reliant on one member’s thinking. Our own Strategic Policy Committee, for example, meets on a quarterly basis to discuss and debate our tactical asset allocation – periodic adjustments to our investment approach that take into account current market conditions. The committee uses an analytical framework that considers economic growth, valuation of asset classes, liquidity conditions, currency risk and policy management. Members use data and judgment to arrive at a shared house view and reach the best outcome for our clients.

Working with an experienced, knowledgeable financial adviser, who has access to a wealth of data and information, can help you to build your financial plan unemotionally and intelligently. This is because your adviser will have learned – through hard work and effort – to use System 2. Investors who lack the financial knowledge and experience of a professional are more likely to be misled by their brain’s default cognitive and emotional rules of thumb.

You can’t take the human behavioural elements out of an organisation completely. Nor would you want to. But by understanding how these thinking systems work, we are able to put the right processes in place for all of us to make better, more considered financial decisions.

If you’d like to find out more about how professional financial advice could help you, request a call back.

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